Performing an Engineering Economy Study

An engineering economy study involves many elements: problem identifi  cation, defi  nition of the objective, cash flow estimation, fi nancial analysis, and decision making. Implementing a structured procedure is the best approach to select the best solution to the problem.

The steps in an engineering economy study are as follows:

1.    Identify and understand the problem; identify the objective of the project. 
2.    Collect relevant, available data and defi ne viable solution alternatives. 
3.    Make realistic cash fl  ow estimates. 
4.    Identify an economic measure of worth criterion for decision making.
5.    Evaluate each alternative; consider noneconomic factors; use sensitivity analysis as needed. 
6.    Select the best alternative. 
7.    Implement the solution and monitor the results.   

Steps in an engineering economy study.
  Figure 1–1  Steps in an engineering economy study.

Technically, the last step is not part of the economy study, but it is, of course, a step needed to meet the project objective. There may be occasions when the best economic alternative  requires more capital funds than are available, or signifi cant noneconomic factors preclude the  most economic alternative from being chosen. Accordingly, steps 5 and 6 may result in selection of an alternative different from the economically best one. Also, sometimes more than one project may be selected and implemented. This occurs when projects are independent of one another. In this case, steps 5 through 7 vary from those above.  Figure 1–1  illustrates the steps above for one alternative. Descriptions of several of the elements in the steps are important to understand.
      
Problem Description and Objective Statement A succinct statement of the problem and  primary objective(s) is very important to the formation of an alternative solution. As an illustration, assume the problem is that a coal-fueled power plant must be shut down by 2015 due to the  production of excessive sulfur dioxide. The objectives may be to generate the forecasted  electricity needed for 2015 and beyond, plus to not exceed all the projected emission allowances in these future years. 

Alternatives These are stand-alone descriptions of viable solutions to problems that can meet the objectives. Words, pictures, graphs, equipment and service descriptions, simulations, etc.  define each alternative. The best estimates for parameters are also part of the alternative. Some parameters include equipment first cost, expected life, salvage value (estimated trade-in, resale, or market value), and annual operating cost (AOC), which can also be termed   maintenance and operating  (M&O)   cost,  and subcontract cost for specifi c services. If changes in income (revenue) may occur, this parameter must be estimated.

Detailing all viable alternatives at this stage is crucial. For example, if two alternatives are described and analyzed, one will likely be selected and implementation initiated. If a third, more attractive method that was available is later recognized, a wrong decision was made. 

Cash Flows All  cash  flows are estimated for each alternative. Since these are future expenditures and revenues, the results of step 3 usually prove to be inaccurate when an alternative is actually in place and operating. When cash fl ow estimates for specifi c parameters are expected to vary significantly from a   point estimate  made now, risk and sensitivity analyses (step 5) are needed to improve the chances of selecting the best alternative. Sizable variation is usually expected in estimates of revenues, AOC, salvage values, and subcontractor costs.

Engineering Economy Analysis The techniques and computations that you will learn and use throughout this text utilize the cash fl ow estimates, time value of money, and a selected measure of worth. The result of the analysis will be one or more numerical values; this can be  in one of several terms, such as money, an interest rate, number of years, or a probability. In the end, a selected measure of worth mentioned in the previous section will be used to select the best alternative.

Before an economic analysis technique is applied to the cash fl ows, some decisions about what to include in the analysis must be made. Two important possibilities are taxes and inflation. Federal, state or provincial, county, and city taxes will impact the costs of every alternative. An after-tax analysis includes some additional estimates and methods compared to a  before-tax a nalysis. If taxes and infl ation are expected to impact all alternatives equally, they  may be disregarded in the analysis. However, if the size of these projected costs is important,  taxes and infl ation should be considered. Also, if the impact of infl ation over time is important  to the decision, an additional set of computations must be added to the analysis.

Selection of the Best Alternative The measure of worth is a primary basis for selecting the best economic alternative. For example, if alternative A has a rate of return (ROR) of  15.2% per year and alternative B will result in an ROR of 16.9% per year, B is better economically. However, there can always be   noneconomic or intangible factors  that must be  considered and that may alter the decision. There are many possible noneconomic factors;  some typical ones are

   •     Market pressures, such as need for an increased international presence 
   •     Availability of certain resources, e.g., skilled labor force, water, power, tax incentives 
   •     Government laws that dictate safety, environmental, legal, or other aspects 
   •     Corporate management’s or the board of director’s interest in a particular alternative 
   •     Goodwill offered by an alternative toward a group: employees, union, county, etc.   

As indicated in  Figure 1–1 , once all the economic, noneconomic, and risk factors have been  evaluated, a final decision of the “best” alternative is made.

At times, only one viable alternative is identifi ed. In this case, the   do-nothing (DN) alternative  may be chosen provided the measure of worth and other factors result in the alternative being  a poor choice. The do-nothing alternative maintains the status quo.

Whether we are aware of it or not, we use criteria every day to choose between alternatives.  For example, when you drive to campus, you decide to take the “best” route. But how did you define   best?  Was the best route the safest, shortest, fastest, cheapest, most scenic, or what? Obvi- ously, depending upon which criterion or combination of criteria is used to identify the best, a different route might be selected each time. In economic analysis,   fi  nancial units (dollars or  other currency)  are generally used as the tangible basis for evaluation. Thus, when there are  several ways of accomplishing a stated objective, the alternative with the lowest overall cost or  highest overall net income is selected.

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